Chapter 3

ASSESSING LIQUIDITY AND OPERATIONAL EFFICIENCY

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Background

It is easier to understand a firms liquidity

If its standard balance sheet is restructured

Emphasize the concerns of its operating and financial managers rather than those of accountants and auditors

This chapter presents a restructured balance sheet

Called the managerial balance sheet Shows why a firm's liquidity is driven by the structure of its managerial balance sheet

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Background

After reading this chapter, students should understand:

How to restructure a standard balance sheet into a managerial balance sheet The meaning of working capital requirement, net long-term financing, net short-term financing, net working capital, current ratio, acid test ratio, and other ratios used to measure, analyze, and manage liquidity How to measure a firms investment in its operating activities using information drawn from its balance sheet The meaning of interest-rate risk and funding risk How a firms operating decisions affect the firms liquidity How to improve a firms liquidity through better management of the firms operating cycle
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The Managerial Balance Sheet

The managerial balance sheet

Helps identify the links between managerial decisions and financial performance Provides a snapshot of the total capital employed (the right-hand side) and the way that capital is invested in the firms assets (the left-hand side)

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EXHIBIT 3.1a:

OS Distributors Balance Sheets.

Figures in millions of dollars

DEC. 31, 1998

DEC. 31, 1999

DEC. 31, 2000

ASSETS
CURRENT ASSETS
Cash Accounts receivable Inventories Prepaid expenses

$104.0

$119.0

$137.0

$6.0
44.0 52.0 2.0 56.0 0.0 56.0 $90.0 (34.0) $90.0

$12.0
48.0 57.0 2.0 51.0 0.0 51.0 $93.0 (40.0)

$8.0
56.0 72.0 1.0 53.0 0.0 53.0

NONCURRENT ASSETS
Financial assets & intangibles Property, plant, & equip. (net) Gross value Accumulated depreciation

(39.0)

TOTAL ASSETS
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$160.0
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$170.0

$190.0

EXHIBIT 3.1b:

OS Distributors Balance Sheets.

Figures in millions of dollars

DEC. 31, 1998

DEC. 31, 1999

DEC. 31, 2000

LIABILITIES AND OWNERS EQUITY

CURRENT LIABILITIES Short-term debt $15.0 $54.0 $22.0 $66.0 $23.0 $75.0

Owed to banks
Current portion of long-term debt Accounts payable Accrued expenses NONCURRENT LIABILITIES Long-term debt Owners equity TOTAL LIABILITIES AND OWNERS EQUITY

$7.0
8.0 37.0 2.0 42.0 42.0 64.0 64.0

$14.0
8.0 40.0 4.0 34.0 34.0 70.0 70.0 $170.0

$15.0
8.0 48.0 4.0 38.0 38.0 77.0 77.0 $190.0

$160.0

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EXHIBIT 3.2a: The Managerial Balance Sheet Versus the Standard Balance Sheet.
THE MANAGERIAL BALANCE SHEET INVESTED CAPITAL OR NET ASSETS Cash CAPITAL EMPLOYED

Short-term debt

Working capital requirement (WCR)

Operating assets less Operating liabilities

Exhibit 3.2 provides a comparison of the managerial balance sheet with a standard one.

Long-term financing Net fixed assets

Long-term debt plus Owners equity

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EXHIBIT 3.2b: The Managerial Balance Sheet Versus the Standard Balance Sheet.
THE STANDARD BALANCE SHEET LIABILITIES AND OWNERS EQUITY Short-term debt Operating liabilities
Accounts payable plus Accrued expenses

TOTAL ASSETS
Cash Operating assets
Accounts receivable plus Inventories plus Prepaid expenses

Long-term financing Net fixed assets

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Long-term debt plus Owners equity

The Three Components Of A Firms Invested Capital

Cash and cash-equivalent assets

Firms hold cash to:

Meet their unexpected expenses Acquire assets on short notice Maintain some compensating balances required by banks, etc.

Investment in fixed assets

Property, plant and equipment Fixed assets alone cannot produce sales and profits The firms operating activities require investments in inventories and receivables generated by the firms operating cycle (see Exhibit 3.3)
The net investment the firm must make to support its operating cycle is the sum of its inventories and accounts receivable minus its accounts payable
Known at the firms working capital requirement (WCR)

Working capital requirement

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EXHIBIT 3.3: The Firms Operating Cycle and Its Impact on the Firms Balance Sheet.
= Change in the balance sheet account

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EXHIBIT 3.4: The Firms Operating Cycle, Showing Cash-to-Cash Period.

An alternative way to describe the operating cycle in terms of the cash-to-cash period is presented in Exhibit 3.4.
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The Components Of Capital Employed

A firms total capital employed can be classified as

Equity and debt or Long-term financing (equity plus long-term debt) and short-term financing (short-term debt)

The combination of equity and debt capital affects the firms profitability and financial risk (see Chapters 5 and 11) The proportions of long-term debt and shortterm debt affect primarily the firms liquidity (the subject of this chapter)
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EXHIBIT 3.6: OS Distributors Managerial Balance Sheets.

All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

DEC. 31, 1998

DEC. 31, 1999

DEC. 31, 2000

INVESTED CAPITAL OR NET ASSETS

Cash Working capital requirement (WCR)1 Net fixed assets TOTAL INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED $ 6.0 59.0 56.0 5% 49% 46% $12.0 63.0 51.0 10% 50% 40% $ 8.0 77.0 53.0 6% 56% 38%

$121.0 100%

$126.0 100%

$138.0 100%

Short-term debt Long-term financing Long-term debt Owners equity

TOTAL CAPITAL EMPLOYED
1 WCR

$ 15.0 106.0 $42.0 64.0

12% 88% $34.0 70.0

$ 22.0 104.0

17% 83% $38.0 77.0

$ 23.0 17% 115.0 83%

$121.0 100%

$126.0 100%

$138.0 100%

= (Accounts receivable + Inventories + Prepaid expenses) (Accounts payable + Accrued expenses).

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The Matching Strategy

The matching strategy suggests that by matching the life of an asset with the duration of its financing source

Firm can minimize its interest-rate risk and funding risk

Although WCR is made up of current assets and liabilities

It is essentially a long-term investment since it will remain in the managerial balance sheet as the operating cycle repeats

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EXHIBIT 3.7: The Behavior of Working Capital Requirement over Time for a Firm with Seasonal Sales.
WCR is assumed to be set at 25 percent of sales Exhibit 3.7 shows that when sales are seasonal WCR will have a seasonal component, and according to the matching strategy, the permanent component of WCR should be financed with long-term funds (long-term debt and equity) and the seasonal component of WCR with short term funds (shortterm debt).
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A Measure Of Liquidity Based On The Funding Structure Of Working Capital Requirement

Although the objective may be a matching strategy

At times a significant portion of a firms working capital is funded with short-term debt
Can create a liquidity problem

This section presents a measure of liquidity based on the funding structure of working capital requirement
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A Measure Of Liquidity Based On The Funding Structure Of Working Capital Requirement

Any long-term financing in excess of net fixed assets (called net long-term financing or NLF) can be used to fund WCR and cash

See Exhibit 3.8 for OS Distributors NLF

The amount of short-term debt in excess of cash is called net short-term financing or NSF

Also shown in Exhibit 3.8

The ratio of NLF to WCR is the firms liquidity ratio Normally, the higher the proportion of WCR financed with long-term funds, the more liquid the firm
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EXHIBIT 3.8a: OS Distributors Net Investment in Its Operating Cycle and Its Financing.
All data from the balance sheets in Exhibit 3.1; figures in millions of dollars
DECEMBER 31, 1998 DECEMBER 31, 1999 DECEMBER 31, 2000

NET INVESTMENT IN THE OPERATING CYCLE OR WORKING CAPITAL REQUIREMENTS (WCR) WCR = [Accounts receivable + Inventories + Prepaid expenses] [Accounts payable + Accrued expenses
[$44 + $52 + $2] [$37 + $2] = $59 [$48 + $57 + $2] [$40 + $4] = $63 [$56 + $72 + $1] [$48 + $4] = $77

THE FINANCING OF THE OPERATING CYCLE Net long-term financing (NLF) = Long-term debt + Owners equity Net fixed assets $42 + $64 $56 = $50
$34 + $70 - $51 = $53 $38 + $77 - $53 = $62

Net short-term financing (NSF) = Short-term debt Cash

$15 - $6 = $9
Percentage of working capital financed long term

$22 - $12 = $10

$23 - $8 = $15

Net long-term financing working capital requirement $50/$59 = 84.7%

Percentage of working capital requirement financed short term

$53/$63 = 84.1%

$62/$77 = 80.5%

Net short-term financing working capital requirement

$9/$59 = 15.3% $10/$63 = 15.9% $15/$77 = 19.5%

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EXHIBIT 3.8b: OS Distributors Net Investment in Its Operating Cycle and Its Financing.
All data from the balance sheets in Exhibit 3.1; figures in millions of dollars
DECEMBER 31, 1998 DECEMBER 31, 1999 DECEMBER 31, 2000

WORKING CAPITAL REQUIREMENT AND ITS FINANCING

WCR $59 NSF $9 NLF $50 15.3% 84.7% 100% WCR $63 NSF $10 NLF $53 15.9% 84.1% 100% WCR $77 NSF $15 NLF $62 19.5% 80.5% 100%

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Improving Liquidity Through Better Management Of The Operating Cycle

A firms liquidity is the consequence of decisions that affect its NLF and WCR

Liquidity position will improve if:

Long-term financing increases, and/or Net fixed assets decrease, and/or WCR decreases

Decisions related to the management of longterm financing and net fixed assets are strategic in nature

Infrequent and prepared well in advance

Therefore, their impact on the firms liquidity can be easily forecast

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Improving Liquidity Through Better Management Of The Operating Cycle

Decisions affecting the firms WCR are related to the management of the firms operating cycle

Made frequently and are difficult to forecast

Therefore, the lower their frequency, the less volatile is the firms liquidity position and the easier it is to manage

Controlling WCR successfully requires the understanding of three basic factors that affect its size (through their impact on WCRs components):

Nature of the economic sector Degree of managerial efficiency Level and growth of sales
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The Impact Of The Firms Sector On Its Working Capital Requirement

The sectoral effect can be measured by the ratio of WCR to sales

Exhibit 3.9 reports this ratio for a number of U.S. industries

Should understand why an equipment manufacturer normally needs more working capital than a grocery store chain to support the same level of sales

Exhibit 3.10 illustrates the ratio calculations for OS Distributors

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EXHIBIT 3.9a: Some Benchmark Ratios of Working Capital Requirement to Sales for a Sample of U.S. Economic Sectors in 19991.
WORKING CAPITAL REQUIREMENT AS PERCENTAGE OF SALES Sector Machinery & equipment Apparel products Textile Aircraft Wholesales: Durables Department stores Steel works Plastic products Paper Computer equipment Motor vehicles 25% 24% 22% 21% 19% 18% 16% 13% 13% 12% 12% Sector Beverages Food Wood products and buildings Publishing Soap & perfumes Electric services Retail: Nongrocery stores Natural gas distribution Wholesale: Nondurables Grocery stores Air transport 10% 9% 9% 9% 6% 4% 4% 2% 0% 0% -3%

Average all sectors: 11%

1 Source:

Calculated by the authors using Compustat data.

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The Impact Of Managerial Efficiency On Working Capital Requirement

Several ratios can be used to estimate the efficiency with which a firm manages the components of its working capital requirement

Inventory turnover
Defined as the ratio of its cost of goods sold to its end-of-period inventories
The higher the inventory turnover the higher the efficiency with which the firm manages its inventories

Average collection period

The number of days worth of sales that have not yet been collected at the date of the balance sheet
The faster the bills are collected, the lower the firms WCR

Average payment period

The number of days worth of purchases that have not yet been paid
The longer the average payment period, the lower the firms WCR

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EXHIBIT 3.10: OS Distributors Management of Its Operating Cycle.

All data from the balance sheets in Exhibit 3.1 and the income statements in Exhibit 2.2; figures in millions of dollars

OBJECTIVE
Working capital requirement (WCR)1 Sales To evaluate the overall efficiency with which the firms operating cycle is managed

DEC. 31, 1998

$59 = 15% $390

DEC. 31, 2000

$77 = 16% $420

Cost of goods sold (COGS) To evaluate the Inventories efficiency with which inventories are managed Accounts receivable Average daily sales2 Accounts payable Average daily purchases2,3
1 WCR

$328 = 6.3 times $52

$400 = 5.6 times $72

To evaluate the efficiency $44 $56 with which accounts = 41 days = 43 days $390/365 $480/365 receivable are managed To evaluate the efficiency $37 $48 with which accounts = 41 days = 42 days $332/365 $415/365 payable are managed

is found in Exhibit 3.6. assume the year has 365 days. 3 Purchases are equal to COGS plus the change in inventories (see equation 3.11). In 1994, inventories were $48, thus purchases (1995) = $328 + ($52 $48) = $332. Purchases (1996) = $353 + ($57 $52) = $358; and purchases (1997) = $400 + ($72 $57) = $415.
2 We

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The Impact Of Sales Growth On Working Capital Requirement

If there is no change in the efficiency with which the firms operating cycle is managed

Can expect WCR to grow approximately at the same rate as sales

Thus, sufficient funding has to be secured so the firms WCR keeps up with the projected sales growth

An unplanned or unexpected growth in sales may create liquidity problems

Inflation also puts pressure on the firms WCR Exhibit 3.11 illustrates the quest of some manufacturing firms for zero WCR
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Traditional Measures Of Liquidity

Traditional measures of liquidity are often not reliable indicators of the firms liquidity

Net working capital

Traditional definition of net working capital (NWC) has a limited value because of its liquidation view of the firm as opposed to the going-concern approach NWC is the same as NLF defined earlier, which once again indicates that NWC is the net result of the firms long-term strategic decisions Exhibit 3.12 shows NWC calculations (both ways) for OS Distributors

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EXHIBIT 3.12: OS Distributors Net Working Capital (NWC) and Current and Quick Ratios.
All data from the balance sheets in Exhibit 3.1; figures in millions of dollars

DEC. 31, 1998

NWC = [Current assets Current liabilities]1 NWC = [Long-term financing2 Net fixed assets]3 Current ratio = Current assets Current liabilities $104 $54 = $50 ($42 $64) $56 = $50 $104 = 1.93 $54 $6 + $44 = 0.93 $54

DEC. 31, 1999

$119 $66 = $53
($34 + $70) $51 = $53

DEC. 31, 2000

$137 $75 = $62 ($38 + $77) $53 = $62 $137 = 1.83 $75 $8 + $56 = 0.85 $75

$119 = 1.80 $66

$12 + $48 = 0.91 $66

Quick ratio = Cash + Accts receivable Current liabilities

1 This 2 Long-term

is the traditional definition of net working capital. financing = Long-term debt + Owners equity. 3 According to this definition, net working capital is the same as net long-term financing (see equation 3.4).

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Traditional Measures Of Liquidity

Current ratio
Often said that the larger the current ratio, the more liquid the firm is
However, a firms current ratio can be increased by Having clients pay their bills as late as possible Maximizing inventories Paying the firms suppliers in a hurry These strategies obviously would not increase the firms liquidity Therefore, the current ratio cannot be considered a reliable measure of liquidity

Acid test or quick ratio

Although the quick ratio is an improvement over the current ratio, it still emphasizes a liquidation view of the firm Also, a firms inventories (which are excluded from the quick ratio on the assumption that they are less liquid than receivables) are often as liquid as the firm's receivables

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